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The perfect Halloween costume

Inflation! Boo! Did I frighten you? No? I just scared Wall Street. Stand on Wall Street in Manhattan between the Federal Reserve and the New York Stock Exchange and tell passersby, "I’m worried about inflation!" You’ll likely elicit a panicked reaction. The past week has seen the markets absolutely devastated by the looming specter of inflation, wafting from a wicked witch’s brew of high energy prices and the economic impact of hurricanes Katrina and Rita. The fear is real, but it is much too overblown by Wall Street. The price of a barrel of oil is down nearly $6 per barrel since Hurricane Katrina struck. The devastation of Hurricane Katrina, while still immense and tragic, is not as great as initially feared. Hurricane Rita did not impact the country as much as anticipated. Juxtapose these disasters against the recent earthquake in Pakistan, and it’s easier to visualize that the effects of the hurricane season were muted compared to what could have been. So why are investors so worried, and why do the markets react so negatively to the prospect of higher inflation? Three reasons–the delay in publishing economic indicators, the shortsightedness of the markets, and the Federal Reserve.

I’ll admit–it’s been a bad week for my investment portfolio, which weighs more heavily in favor of NASDAQ (read technology) stocks. My recent purchases I lauded in previous blog postings, including Caribou Coffee and Cogent Technologies, have been clobbered over the last seven days. I believe both equities are being dragged down by the market, not by their fundamentals, and I am still bullish on their longer-term prospects. Once the market turns upward again, I think they will recover. So I’m sour grapes when it comes to investor panic over inflation fears that have not yet materialized. The seers of Wall Street determine market momentum partly based on reports such as Consumer Confidence and manufacturing output published monthly and quarterly by many organizations, including the Federal Reserve. These reports guage past data and help indicate future economic prospects. Unfortunately, the delay between when the data is gathered, say in September, can be misleading when it is published in October and the data are influenced by large, volatile swings. September’s data were impacted by high energy prices in September, but prices has come down in October. The one- to three-month delay in publishing economic indicators leads the market to react to news that happened the month or quarter before, not when it is currently happening.

The markets’ overreliance on periodic economic reports, corporate earnings announcements, and on the spot price of raw materials such as crude oil creates knee-jerk reactions on Wall Street. It causes the market to be too short-sighted and panic at any hint of bad news. For example, the price of crude oil falls substantially over the previous month and the market shrugs, yet when it goes up 50 cents a barrel in one day, the market plunges. Apple Computer’s fourth quarter profits rise 400%, yet the company misses analysts’ targets, causing the stock to tank, taking the entire technology sector down with it. The market transforms aggressive analyst targets for companies such as Apple into referenda on the future growth prospect of the entire sector. This is extremely short sighted. Call it "irrational exuberance" or "irrational trepidation." Of course, good news can have the same, irrational effect on markets. As one who prefers stable markets, I would rather sacrifice higher potential reward for less volatility.

Finally, the Federal Reserve is agitating the markets by insisting that inflation is the nation’s biggest economic concern, and it insists that it will continue to raise interest rates to combat inflation. The market now fears that the Fed may continue to raise rates indefinitely. I’m not sure I completely trust Fed Chair Alan Greenspan and the Federal Reserve to properly set interest rates this time around. After all, the Fed was widely criticized following the 2000-2002 dot.com bust for holding interest rates too low for too long, causing the U.S. economy to overheat and resulting in the 2000 stock market crash. Many now say that the Fed is moving too aggressively to raise interest rates, needlessly hampering a vulnerable, tepid economy. If the Fed isn’t careful and overshoots the ideal rate, the next bubble to burst won’t be the technology sector–it will be the U.S. housing sector. A housing crash would be very bad indeed. Fighting inflation is important, but the Federal Reserve must handle it so that the economy comes in for a soft landing, not a crash.

And so, during this Halloween season, when you are looking for that perfect costume to wear on Halloween, I recommend that you dress up as Federal Reserve Chair Alan Greenspan and wear a bright, white shirt with one word painted across the front and back of the shirt in bright, red letters–"INFLATION." That will be the scariest costume of all this Halloween season.